VAT for small businesses: what you need to know

Value Added Tax is one of those topics where small business owners often know just enough to be uncertain. When do you have to register? What can you claim back? What happens if you make a mistake? This guide covers the essentials without the accountancy jargon.

The registration threshold

You must register for VAT when your VAT taxable turnover exceeds £90,000 in any rolling 12-month period. The 12 months doesn't have to align with the tax year; it's any 12-month period, so you need to keep a running total of your turnover throughout the year.

You can also register voluntarily below the threshold, which makes sense if you're selling primarily to other VAT-registered businesses. They can reclaim the VAT you charge them, so it doesn't put you at a competitive disadvantage, and it lets you reclaim VAT on your own purchases.

The three main VAT rates

Standard rate is 20%, which applies to most goods and services. Reduced rate is 5%, which covers things like domestic energy and certain renovation work. Zero rate (0%) applies to most food, books, children's clothing, and new residential builds.

Some things are VAT exempt entirely, meaning you don't charge VAT but also can't reclaim VAT on purchases related to those activities. Healthcare services, financial services, and education are common examples. The distinction between zero-rated and exempt matters for your VAT accounting.

What you can claim back

You can reclaim VAT on business purchases, provided those purchases relate to your taxable activities. Office supplies, equipment, software subscriptions, professional services, business travel. The VAT has to be shown on a valid VAT receipt or invoice.

You can't reclaim VAT on business entertaining, on personal purchases mixed with business ones, or on purchases related to VAT-exempt activities. If your business has a mix of taxable and exempt activities, there are partial exemption rules that get complicated quickly, and it's worth getting your accountant involved.

VAT schemes for small businesses

The standard VAT scheme means you account for VAT based on when you invoice (accruals basis) or when you receive payment (cash accounting basis). Cash accounting is generally better for cash flow since you don't pay VAT to HMRC until the customer has actually paid you.

The Flat Rate Scheme is worth knowing about if your turnover is under £150,000. Instead of working out the VAT on every transaction, you apply a fixed percentage to your gross turnover. The percentage varies by industry. You might end up paying less than the VAT you collect, and you keep the difference. A quick calculation with your accountant will tell you whether it's beneficial for your sector.

Making VAT returns

Most businesses file quarterly VAT returns, though monthly or annual schemes are available. Under Making Tax Digital, your returns must be submitted through MTD-compatible software, not by logging into the HMRC portal and typing figures in manually.

The return itself summarises your output tax (VAT you charged customers), your input tax (VAT you paid on purchases), and the difference, which is either what you pay HMRC or what HMRC pays back to you.

Mistakes and penalties

Common mistakes include charging the wrong rate, forgetting to register on time, or miscalculating partial exemptions. HMRC can charge penalties for late registration, late filing, and late payment.

If you think you've made a VAT error, it's almost always better to correct it proactively than wait for HMRC to find it. For errors below a certain threshold, you can correct them on your next return. Larger errors need to be disclosed separately.

Getting set up properly

Good VAT management starts with good record-keeping. Every purchase receipt needs to be stored, every invoice you send needs a VAT number on it if you're registered, and your accounting software needs to track VAT correctly on every transaction.

If you're registered for VAT and not yet using MTD-compatible software, now is the time to change. The record-keeping requirement is already law, and doing it properly from the start saves a lot of pain at return time.